A vague letter from JP Morgan Chase CEO Bill Harrison has caused an outbreak of head scratching, worry and speculation in the private equity industry. But mostly, the letter has caused an outbreak of math, as market participants try to calculate how exactly the bank will go about cutting its private equity program in half.
The letter, dated Dec. 3 and circulated internally, explains that the bank’s private equity arm, JP Morgan Partners, will be “reduced” from roughly 20 per cent of common equity to 10 per cent. Just one week earlier, JP Morgan Partners announced the closing of a gargantuan $7.7bn global private equity fund, $6.25bn of which was to come from the parent company. Now that commitment is in question, as is the fate the bank’s $4bn portfolio of fund investments.
Harrison’s letter is a case study in corporate obfuscation. “It’s purposely very hard to decipher,” says a person close to JP Morgan Partners.
The missive relays the following information:
- A “task force” led by Don Wilson, an executive officer of JP Morgan Chase, “recently undertook a strategic and tactical review” of JP Morgan Partners, and compared the business against “various competitive benchmarks.”
- The task force concluded that JPMorgan Partners continues to be “strategic for the firm,” that the private equity group needs to “restore fair value returns to above-hurdle SVA and to reduce its earnings volatility.” Harrison said JP Morgan Chase should reduce the amount of capital it invests in private equity to approximately 10 per cent of common equity, from the current level of approximately 20 per cent.
- JP Morgan Partners will reduce, “and in some cases exit,” non-core businesses and investments.
- JP Morgan Partners will “increase the percentage of third-party capital invested in its core direct investment portfolio, with the goal of reducing the amount of capital invested by the firm in this asset class.”
At the risk of being overly Talmudic with this bit of corporate communication, a close reading of the text indicates a broad plan of action for JP Morgan with regard to its private equity business – the bank plans to sell off its partnership investments and scale back its commitment to its freshly closed direct investment fund.
JP Morgan Partners is a large organization that houses direct equity and mezzanine investments, leveraged loan products, and commitments to private equity partnerships, all of which is overseen by Jeffrey Walker. But the direct investment program is Walker’s baby. According to a person who used to work at JP Morgan, “[Walker] has been working with Harrison for a decade to ensure the never-ending gravy train” of funds flowing to JP Morgan Partners for direct investments.
In 1999 and 2000, JP Morgan Partners, then called Chase Capital Partners, was the darling of the company, turning in unbelievable profits thanks to its portfolio heavy with tech and telecom companies. Business was good enough to convince the parent company to commit $8bn to a fund with a $13bn target.
As the market melted, so too did enthusiasm for the private equity business. The group formerly known as Chase Capital had to write down the value of its portfolio quarter after quarter, thus exacerbating the already formidable problems of its new parent company. A year ago, the bank reduced its commitment to the fund to $6.25bn. Outside investors also grew shy – JP Morgan raised $825m from third parties in a disappointing first close.
Last week, JP Morgan’s appetite for direct private equity appeared to be holding steady. The fund held a final close on $1.45bn from third parties, and if you count in the $6.25bn in in-house capital, that makes $7.7bn – the largest pool of private equity investment capital ever seen.
Outside limited partners to the fund include heavy hitters CPP Investment Board, Caisse de Depot, New York State Common and Michigan Retirement Fund. The bank’s commitment was never a guarantee. The outside investors were told that JP Morgan “intends to commit” $6.25bn to the fund. “It was as close as they could get to a commitment without being legally bound,” says a source.
The Harrison letter strikes some as, at best, ill-timed, and others as, at worst, meticulously timed. “It’s no coincidence that this came out right after the fund close,” says a former JP Morgan insider.
At least one LP to the fund was described at being “furious” about the timing of the letter.
Mark Weisdorf, vice president for private market investments at CPP, says he has already spoken with executives from JP Morgan Partners and is “not uncomfortable in any way, shape, or form” with Harrison’s letter. Instead, he sees it as part of a larger, ongoing trend among large banks to reduce exposure to non-core private equity activity. JP Morgan Parters’ third-party fund management business, Weisdorf says, is core. In any case, Weisdorf says his pension did significant due diligence on the issue of whether JP Morgan would remain committed to the fund. “We believe the bank would talk to us well in advance of considering any reduction in their commitment to JP Morgan Partners,” Weisdorf says. “They wouldn’t close, and then a few weeks later change their commitment. No professional organisation that wants to do business behaves that way.”
A more likely area for cutting, then, is what bank insiders sometimes call the “Jimmy Lee portfolio.” Jimmy Lee is the Chase bigwig who, during the late 1990s, commanded the lucrative syndicated loan market and provided the debt for many a buyout. As was the practice of many banks, Chase made commitments to funds managed by big private equity firms as a relationship-building exercise. Fund commitments also don’t hurt in generating investment banking business among financial sponsors. Of course, Chase/JP Morgan also wanted to make money on their fund investments, but these interests now occupy too large a spot on the balance sheet. By one estimate, JP Morgan Chase has commitments to private equity funds worth approximately $4bn. That may be cut to $2bn. It may be cut to zero. (If so, could this be the “motherlode” that all the big secondary players have been waiting for?)
Selling off the entire fund portfolio, however, would not quite halve JP Morgan’s private equity exposure. Some market observers wonder if the bank will be able to resist chipping away at its commitment to the direct investment fund. This, too, doesn’t bother Weisdorf much. “We didn’t make a decision to invest based on the dollar amount committed by JP Morgan,” he says. “It would have no impact on us if they were to call and say, ‘Look, we’re asking our partners if we can go from $6.25bn to $4bn.’ That wouldn’t matter.”
Indeed, the exact amount that JP Morgan invests alongside its third-party private equity investing business would not have a material impact on its performance. The depth of commitment to the investment process would. Harrison’s letter seems to indicate that JP Morgan Partners will continue to be a major player in the market, but it will increasingly play with other people’s money.
At least, that’s all we can tell from reading other people’s mail.